7.1 Financing Concepts, Notes, Mortgages, and Deeds of Trust

Two Instruments, Two Jobs

Every financed purchase produces two separate documents, and the exam loves to test which does which.

• Promissory note — the borrower's written promise to repay. It states the principal, interest rate, payment schedule, and maturity date. The note is the debt; it is a negotiable instrument the lender can sell.
• Security instrument — a mortgage or deed of trust that pledges the property as collateral. It creates the lien that lets the lender foreclose if the note is not paid.

The single most common trap: a question describes "the document that creates the debt" (the note) versus "the document that secures the debt" (the mortgage/deed of trust). Keep them separate.

Mortgage vs. Deed of Trust

The instruments differ in their parties and in how foreclosure works.

A memory hook for the mortgage parties: the suffix -or gives away the property pledge (mortgagor = borrower who gives the security), and -ee receives it (mortgagee = lender). The deed of trust adds the trustee, who holds title and conducts the trustee's sale on default, then reconveys title at payoff.

Lien Theory vs. Title Theory

Who holds legal title during the loan term depends on state classification.

• Lien theory (majority of states): the borrower holds title; the lender holds only a lien. Foreclosure is typically judicial.
• Title theory: the lender (or trustee) holds legal title until the debt is paid; the borrower has equitable title and possession.
• Intermediate theory: title passes to the lender only upon default.

Underlying all three is hypothecation — pledging property as security for a debt while keeping possession and use. The borrower lives in and uses the home throughout the loan; only the security interest is pledged. Contrast this with a pawn, where the lender takes possession of the collateral.

Mortgage Clauses You Must Know

Clauses appear constantly, often as the entire question.

• Acceleration clause — on default, the lender may demand the entire unpaid balance at once. Without it, a lender could only sue for missed payments.
• Alienation clause (due-on-sale) — the full balance becomes due if the borrower transfers/sells the property. This blocks a buyer from simply taking over the old loan.
• Defeasance clause — when the debt is paid in full, the lender must release the lien (record a satisfaction or, with a deed of trust, a reconveyance).
• Prepayment clause / penalty — governs early payoff; a penalty compensates the lender for lost interest.
• Subordination clause — a lienholder agrees to let its lien move to a lower priority so a new loan can take first position.

Exam trap: acceleration is triggered by default; alienation is triggered by sale or transfer. Do not swap them.

Lien Priority and Assumptions

General rule: "first in time, first in right" — liens are paid in the order recorded, except property-tax and special-assessment liens take priority over everything, regardless of when recorded. A subordination agreement is how parties deliberately rearrange this order.

When a buyer takes over an existing loan, the exam distinguishes:

• Assumption — the buyer becomes personally liable on the note; if the lender releases the seller (novation), the seller is off the hook.
• Subject to — the buyer makes payments but does not assume personal liability; the original borrower remains liable. The due-on-sale clause usually prevents both without lender consent.

A purchase-money mortgage is seller financing taken back by the seller; in many states it gets a special priority as to the same property.

Note vs. Security Instrument; Mortgage vs. Deed of Trust

Real-estate financing always involves two documents working together. The promissory note is the borrower's personal promise to repay the debt and is the evidence of the debt itself. The security instrument pledges the property as collateral. A mortgage is a two-party security instrument between borrower (mortgagor) and lender (mortgagee). A deed of trust is a three-party instrument adding a neutral trustee who holds title (or a lien) on behalf of the beneficiary (lender) until the debt is paid.

The distinction controls foreclosure. A mortgage typically requires judicial foreclosure through the courts. A deed of trust usually permits a faster nonjudicial foreclosure under a power-of-sale clause. Key clauses to recognize: the acceleration clause lets the lender demand the entire balance on default; the alienation (due-on-sale) clause lets the lender demand payoff if the property is sold; and the defeasance clause requires the lender to release the lien once the debt is satisfied. Hypothecation is pledging property as security while retaining possession.

Amortization and Equity Buildup

Most residential loans are fully amortized: each level payment covers the period's interest first, and the remainder reduces principal. Early in the term most of the payment is interest, so equity builds slowly; late in the term most goes to principal. A balloon loan amortizes on a long schedule but requires a large lump-sum payoff before that schedule completes. A straight (term) loan is interest-only with the full principal due at the end. Recognizing which structure a question describes tells you how the borrower's equity changes over time and whether a refinance will be needed at maturity.